It’s well known that the Australian equity market is only around 2% of Global equity markets. When we have allocations that overweight the Australian equities asset class compared to the Global equities asset class in our portfolios, it is typically justified due to the benefits of franking credits, higher dividends, and perhaps familiarity. The primary risks associated with the Australian equity market are mostly the concentration therefore lack of diversification…it is really dominated by two sectors, financial services (~50%) and materials (~15%).
When choosing strategies or managers for each asset class, portfolio constructors will often look at capturing or avoiding particular systematic risks. For example, we may combine “value” and “growth” styles or perhaps acknowledge particular anomalies and bias a portfolio towards a “value” or “quality” styles across a variety of equity markets, and other systematic risks such as size, momentum, low volatility, or perhaps illiquidity may also be considered, amongst others. However, I think it’s fair to say the impact of systematic risks is rarely considered across asset classes … so I believe there may be a few unanswered questions of which one is … what systematic risks does the Australian equities asset class bring to the global equities asset class?
I’m glad I asked…
Without a deep dive analysis, one might argue that compared to major developed markets, Australia’s high dividend yield, currently lower PE Ratio, and generally smaller companies, one might think the Australian equity market behaves like a global small cap with a value style tilt. Perhaps the high commodities exposure and economic link with China might suggest there’s a growth component and/or behaviour that is emerging markets-like. So what is the truth?
Chart 1
Source: Delta Research & Advisory
Without boring you with too much detail with respect to the analysis leading up to the above chart. I can tell you that Chart 1 shows the risk contribution or risk “make-up” of the Australian equity market based on a number of global equity market risk factors. Namely,
- Global Market Risk (MSCI World GR AUD risk premium to Cash)
- Value (MSCI World Value minus MSCI World Growth)
- Size (MSCI World Small minus MSCI World Large)
- Emerging Markets (MSCI EM minus MSCI World GR)
- US Dollar (US Dollar vs Australia Dollar)
- Idiosyncratic (Everything thing else) … which I assume may be mostly Australian company specific risks
Each point on the chart represents a rolling 3 year contribution to risk of the various factors mentioned above. Whilst numerous studies of managed funds have shown high levels of risk contribution from the market (e.g. more than 90% from the famous Brinson, Hood, Beebower study of US Pension funds), the contribution to the Australian equity market risk from the global equity market has been consistently less than 50% since the start of this analysis in 2001 (don’t forget the rolling 3 years, hence why the chart starts at 2004).
The global Value factor (Purple) barely gets a look-in, but there are strong risk contributions from…
- Size (Red colour – until the 3 years to mid-2014)
- Emerging Markets (Orange), and
- US Dollar (Green – particularly since the 3 years to mid-2007)
Idiosyncratic risks (or those risks that can’t be captured by the others – brown colour) are a very large contributor to total risk and over the last three to four year has contributed between 60% to 80% of total Australian equity market risk. From a portfolio construction perspective, this may be a good thing. Why? Because, these idiosyncratic risks, which are possibly mostly Australian company-specific, are uncorrelated with global equities and the other systematic factors…this means the Australian equities asset class does carry with it a reasonable level of diversification…or at least lack of correlation.
So, having established the contributions to risk, how big are these contributions?
Chart 2 shows the global market beta has averaged around 0.55 over the last 15 years or so, suggesting the Australian market in the context of global equities is a low beta strategy. As shown in Chart 1, this risk factor is not the majority contributor to risk, so there’s a lot more to Australian equities than behaving like a low beta Global equities strategy, but nevertheless it is still significant and having lower relative risk than the global share market may not be a bad thing.
Chart 2
Source: Delta Research & Advisory
Given its low contribution to overall risk, unsurprisingly, the Value risk factor is pretty much zero…it jumps between being “value”-like (above the zero line) and “growth”-like (below the zero line) to average slightly growth-like at -0.08 but it’s not at all statistically significant so can be ignored. The Australian market is neither a value or growth market.
The Size factor, has mostly been positive and strongly so. This suggests the Australian equity market has mostly behaved like a small-cap biased global equities strategy … and considering the average market cap of the Australian market that should also come as no surprise given what we know…let’s face it, Australian companies are nowhere near as big as Apple, Microsoft, etc. In fact, the combined market cap of those 2 companies alone is more than the Australian equity market as a whole.
The Emerging Markets risk factor, which I’ve treated as an extension to the Global Market, is also significantly positive suggesting that Australian equity market performance has a positive correlation with the performance of Emerging Markets. However, with levels consistently around 0.5, the Australian market also has lower Emerging Markets beta so has slightly lower price volatility impact. This is probably due to our close trading relationship with China coming through, but at least it comes with slightly lower risk.
And the final systematic risk, being the US Dollar relationship with the Aussie dollar, is also a very significant factor utility of over 0.5 (and up to 0.8 in recent years) suggesting that on average, when the Australian dollar falls by 10%, it has a performance drag on the Australian market by around 6%. This US Dollar factor might be regarded as an economic factor, as the Australian dollar weakens when the economic outlook weakens, so this result is also not too surprising.
That leaves, the “Pure Alpha” which is the additional return the Australian equities market provides after the above-mentioned systematic factors are removed. Given the significant overweight most portfolios have to Australian equities, it is pleasing to say that since 2001 this higher allocation has produced an average risk-adjusted alpha of a positive 2.9%pa. The alpha hasn’t always been positive, particularly in recovery years following the GFC, but it does suggest the inclusion of Australian equities as an asset class has been a worthy one … and these figures don’t include franking credits which would add even more alpha (say around another ~1.5%pa).
So all-in-all, over the past 15 years the Australian equity market has shown it is driven by some global systematic factors including global equity markets, emerging markets, global small caps, plus some US Dollar influence. The Australian equity market cannot be seen as either value or growth and a large proportion of its performance is probably unique to Australian conditions and hopefully the positive alpha that has been generated over that time can continue.